What next for the Aussie Dollar

It has been a turbulent few weeks for financial markets, including for the Aussie dollar. The AUD has been on a roller coaster, having reached a high of 81.2 US cents in late January and a low of 77.7 US cents about 10 days ago having traded at a low around 75 cents in December.

It is currently trading around 79.5 US cents, with the market divided about which direction will break over the next 12 months.

Foreign exchange markets are driven by many factors. For the Australian dollar, there are some powerful influences that have shown to determine its fortunes.

One of those is the gap in interest rates between Australian and the rest of the world. When Australian interest rates are substantially above those of the rest of the world, there is often a bias from investors towards the AUD which drives it higher. When the interest rate gap compresses, the appeal of the AUD is reduced.

Which brings us to a fascinating situation at the moment, when we compare Australia and the US. With the US Federal Reserve embarking on a series of interest rate increases and the Reserve Bank of Australia squarely on hold, the interest rate gap between Australia and the US is effectively zero. This is not only for the official cash rate, but also for 10 year government bonds.

This is a rare occurrence and prospective changes in the interest rate gap is one reason why the risks favour the AUD falling back towards 70 US cents over the next year or so.

Current market expectations are for the interest rate gap between Australia and the US to widen to 100 basis points or more in favour of the US. If this happens, global investors risk shying away from the AUD which will see it weaken.

Commodity prices are another driver of AUD and the recent strength in base metal prices, in particular, provides an explanation why it has been resilient in the face of the change in the interest rate gap.

Given the dominance of commodities in Australia’s export base, when prices of iron ore, coal, gas, gold, beef and wheat fluctuate, so do export receipts and national income.

When commodity prices are trending higher, export receipts increase. This extra export revenue boosts national income and GDP growth which in turns improves investors confidence and in turn the AUD.

The peak of the commodity price boom of 6 or 7 years ago coincided with the AUD reaching $1.10 US. The impact of what the RBA described as a “one in 150 year boom” was so powerful that nominal GDP growth approached 10 per cent, government revenue rose to the highest level ever seen and even with excessive government spending, the budget remained in substantial surplus.

Other factors, such as risk, stability of the government, foreign direct investment and importantly global economic and political news, can also impact the AUD.

For now, the volatility in the Aussie dollar around that 80 US cent level looks assured while there is conflicting news on the issues that determine its value.

If, however, the interest rate gap between Australia and the US moves strong in favour of the US over the next few months and commodity prices edge lower due to the lift in supply and a cooling in global demand, the risks favour a move towards 70 US cents.

If local political and policy risks build with the Federal election, which is due some time in the next year or so, we could even see the AUD dip below 70.